You Can Still Make a Small Fortune

There's an old joke that says the easiest way to make a small fortune in the airline business is to start with a large fortune. There's more than a mere tidbit of truth to that joke. The industry's history is filled with bankruptcy liquidations and restructurings, and that problem won't be going away any time soon.

The airline industry faces powerful customers and suppliers, barriers to exit, and woeful dynamics that encourage overexpansion. Worse still, airplanes cost a lot to buy and a lot to run, whether they fly half-empty or filled to capacity. Add to that extremely long lead times for new planes -- often measured in years -- and you wind up with a situation where costs are fixed, but revenue is unpredictable.

It's ugly up thereThose structural problems in the industry lead to frequent, heavy, and costly price wars. Since it costs almost as much to fly an empty plane as a full one, airlines will often heavily discount tickets in order to get something for a seat. And since airplanes tend to be mobile by their very nature, when an airline finds an abnormally profitable route, its competition can quickly adapt by shifting part of their fleets.

The result is an industry where many of the large players struggle to maintain profitability and avoid bankruptcy. That makes investing in airlines a minefield -- unless you happen to be looking for a stock to short.

Shorting isn't for everyone, of course. After all, you can get yourself in a position where you lose more than you've invested. Meanwhile, your gains are limited, since no stock can drop below $0.

But if you're going to short an airline, there may be no finer a candidate than the biggest one of them all, Delta (NYSE: DAL) . Its current incarnation was formed through the merger of two recently bankrupted entities -- the prior Delta and Northwest. And while emergence from bankruptcy often gives a company financial strength by severing the mistakes of its past, Delta doesn't seem to be as strong as you'd expect from an industry titan.

What's wrong with this picture?Delta has lost money in 13 of the past 17 quarters. Its balance sheet shows virtually no overall shareholders' equity, and a tangible equity deficit of more than $14 billion. Even among members of its rough-and-tumble industry, that's a pretty poor showing:

On the surface, it may appear that US Airways, along with UAL and AMR (the parent companies of United and American Airlines, respectively) have uglier balance sheets. But when you look past the net equity, and focus only at the tangible stuff -- the airplanes themselves, for instance -- Delta sits in an unfortunate class by itself.

Of the old-line major airlines, only Continental's balance sheet looks anywhere near financial health, with a "mere" $56 million tangible equity deficit. And even so, all five of those legacy carriers have had trouble sustaining profitability -- a testament to the difficulties of the industry. In fact, only low-frills pioneer Southwest and similarly value-focused JetBlue maintain what can be considered really decent balance sheets, or anything close to regular profitability.

As Warren Buffet has said, "When a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact." When it comes to the airlines, truer words have never been spoken.

So why look now?To be sure, while the industry in general, and Delta in particular, have less-than-stellar track records, Delta did post a real profit in its most recent quarter. To top it off, analysts are expecting blue skies for at least the next year. Yet, on the flip side, as Buffett also said, "You pay a very high price in the stock market for a cheery consensus."

How to short successfullyPut Buffett's words of wisdom up against the company and the industry, and the message becomes clear: If you're going to short a stock, pick a troubled company in a troubled industry when everything looks rosy. If that doesn't describe Delta within the airline industry, I'm not quite sure what does.

If you're interested in protecting your portfolio from ticking time bombs, or shorting stocks for big gains, let me send you a new report, "5 Red Flags -- How to Find the Big Short," by John Del Vecchio, CFA. He's a leading forensic accountant who's made a good deal of money identifying troubled companies in troubled industries. To get your absolutely free report, simply enter your email in the box below.

At the time of publication, Fool contributor Chuck Saletta did not own shares of any company mentioned in this article. The Fool has a disclosure policy.

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